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Brazil, a member of the Group of Twenty advanced and emerging economies and the world’s fifth biggest economy, has a vibrant financial sector but will need to keep an eye on risks from abroad as well as at home.

Stock exchange in São Paulo, Brazil: the financial system is exposed to the effects of volatile international markets (photo: Sebastiao Moreira/EPA/newscom)

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Brazil’s financial system has grown in size, diversification, and sophistication, according to the International Monetary Fund’s latest assessment of the country’s financial system.

Over the past decade, financial sector assets more than doubled owing to the stable economy, the expansion of the securities and derivatives markets, and money pouring in from institutional investors from home and abroad.

Thanks to deft policies and built-in cushions, Brazil’s financial system weathered the global crisis that began in 2008 remarkably well. Now, policymakers need to navigate the turbulent global economy and monitor for signs of home-grown financial trouble, the IMF said.

Main risks

Like the rest of the Brazilian economy, the financial system is exposed to the effects of volatile international markets, especially for commodities and capital.

“There is a risk that the financial system may become a victim of its own success at home,” said Dimitri Demekas, an assistant director in the IMF’s Monetary and Capital Markets department and head of the team that conducted the assessment. “Rapid credit expansion in recent years has supported domestic economic growth and broader financial inclusion, but could also create vulnerabilities.”

There are indications of emerging strains in some sectors and asset classes, notably indebted households and rapidly rising housing prices in prime locations, such as São Paulo and Rio de Janeiro. These concerns are mitigated by strong banking supervision and significant capital and liquidity buffers in banks, but require close scrutiny, better data, and readiness to intervene to cool these hot spots, if necessary.

In addition, as interest rates in Brazil continue to decline to international levels, the increasing search for yield among domestic investors may lead to underpricing of risk and the buildup of asset price bubbles.

“A new set of risks may lie just over the horizon. This will require watchful monitoring going forward,” Demekas said.

In the wake of the crisis, the IMF has strengthened its surveillance of countries’ financial systems. Since 1999, the IMF has monitored countries’ financial sectors on a voluntary basis through the Financial Sector Assessment Program , conducted jointly with the World Bank in low-income and emerging market countries, where the World Bank covers financial development issues.

In 2010, the Fund made these checks of financial health a mandatory part of its surveillance every five years for 25 countries with systemically important financial sectors, including Brazil.

Key reforms

Brazil has strengthened the oversight of its financial system: it is risk based, intrusive, and sophisticated, and has a high degree of compliance with international standards.

Brazil also has a well-developed crisis management framework that, together with other policy measures, helped insulate the financial system from the impact of the global crisis in 2008.

But the financial system needs more reform, according to Demekas. Instead of looking backwards, “the system should be strengthened to be able to withstand a wide range of possible future shocks,” he said.

The assessment recommended the government enact a series of measures, including

• Strengthen the central bank’s mechanism for providing emergency funding to banks in the event of a crisis in the financial system

• Reform the governance of the deposit insurer, Fundo Garantidor de Créditos—a step that was already implemented shortly after the assessment—tighten the criteria for providing assistance to banks, and ensure a secure and adequate source of funding in case of a crisis

• Strengthen legal protection for all financial sector supervisors and

• Upgrade the committee in charge of systemic risk monitoring, crisis preparedness and management, and include the Fundo Garantidor de Créditos.

In addition to buttressing the system against future shocks, the key challenge over the coming years is to ramp up the financial sector’s contribution to Brazil’s long-term growth.

Despite progress in recent years, “Brazil is still stuck in a high interest rate-low duration equilibrium,” Demekas said.

While this helps keep the system stable and profitable, it prevents the development of private long-term finance.

Moving the system away from this equilibrium will require sustained efforts beyond the financial sector: continued economic stability, strengthening domestic savings, and improving the business environment.

It will also require steps to lengthen the duration of financial contracts, reform housing finance, and shift the role of state-owned banks—especially the development bank Banco Nacional de Desenvolvimento Econômico e Social—toward supporting capital market development through crowding-in private sector finance.

2012 is a busy year as the IMF evaluates 18 countries’ financial health—ranging from Japan and France to Vietnam and Nigeria—to spot any potential trouble on the horizon. The IMF then produces a detailed report that includes recommendations for the country on how to strengthen its financial stability.

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